Original issue discount (OID): Overview, definition, and example
What is Original Issue Discount (OID)?
Original issue discount (OID) refers to the difference between the face value (or par value) of a debt instrument, such as a bond or note, and its original issue price, which is lower than its face value. OID arises when a bond or other debt instrument is issued at a price below its face value, meaning that the issuer sells the bond for less than the amount that will be paid back to the holder at maturity. This discount represents the interest income that the bondholder will earn over the life of the bond, even though no actual interest payments may be made during the term of the bond.
OID is considered a form of interest income, and for tax purposes, the discount is typically amortized over the life of the bond, with the bondholder recognizing the discount as income over time, rather than all at once.
Why is Original Issue Discount important?
OID is important because it impacts both the issuer and the bondholder. For issuers, OID allows them to raise funds at a lower immediate cost compared to issuing a bond at its full face value, as the bondholder essentially receives the bond at a discounted price. For bondholders, OID provides an opportunity to earn interest income, which accumulates over time, even if the bond does not pay periodic interest.
From a tax perspective, OID has significant implications, as it must be amortized over the life of the bond, and the bondholder must report this as income. For issuers, the OID is treated as a form of interest expense, which can be deducted from their taxable income.
Understanding Original Issue Discount through an example
Let’s say a company issues a 5-year bond with a face value of $1,000, but instead of selling the bond for the full $1,000, it sells it for $950. The $50 difference between the face value and the issue price represents the OID. The bondholder will receive $1,000 when the bond matures, but they effectively paid $950 for it. Over the 5 years, the bondholder will recognize the $50 as interest income, either in equal installments or according to a specific amortization schedule, depending on the tax rules applicable.
In this example, even though the bond does not make periodic interest payments (a zero-coupon bond), the bondholder is still able to earn interest through the OID. The OID is the equivalent of the interest that the bondholder would have received had the bond been issued at its full face value.
An example of an Original Issue Discount clause
Here’s how an OID clause might appear in a bond agreement:
“The bonds issued by the Company are being sold at an Original Issue Discount of [X]% of the face value. The bondholder will not receive periodic interest payments but will instead receive the full face value of the bond at maturity. The OID amount will be amortized over the term of the bond and treated as interest income for tax purposes.”
Conclusion
Original issue discount (OID) is an important concept in debt financing, where bonds or notes are issued at a price lower than their face value, with the difference being treated as interest income. OID provides benefits to both the issuer, by allowing them to raise funds at a lower immediate cost, and to the bondholder, by providing interest income over time. OID must be carefully managed for tax purposes, with the discount typically amortized over the life of the bond, ensuring that both parties comply with tax regulations while benefiting from this financial arrangement.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.